Tracking error and tactical asset allocation

We report results from our investigation of the relationship between statistical measures of tracking error and asset allocation restrictions expressed as admissible weight ranges. Tracking errors are typically calculated as annualized second moments of return differentials between a portfolio and a benchmark. In practice, however, constraints on tactical deviations from benchmark weights are often imposed on the portfolio manager to ensure adequate tracking. Simulating various investment strategies subject to such constraints, we illustrate how the size of acceptable deviations from the benchmark relates to the statistical tracking error. An example based on actual market data indicates that imposing fairly large tactical asset allocation ranges produces surprisingly small tracking errors. We also found that TAA restrictions should restrict not only the tactical ranges of the individual asset classes but also, and perhaps even more importantly, the tracking of the individual asset classes.